Deferred Revenue & Net Working Capital Adjustments

by David Rodeck, Demand Media

Deferred revenues are payments made for goods for future delivery.

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Receiving deferred revenues can be an financial headache. Because deferred revenue gives you cash for a future liability, you must be careful in properly accounting for the transfer. If you do not understand how to properly record deferred revenues, you may miscalculate your current net working capital and face cash flow problems in the future.

Current Assets and Liabilities

Your company's balance sheet splits between what you own, known as your assets, and what you owe, known as your liabilities. Current assets include all assets expected to be cash within one year. They include cash, accounts receivables and inventory. Current liabilities are obligations you are expected to pay within one year. These include accounts payable, accrued liabilities and all short-term debt.

Net Working Capital

The net working capital measurement estimates your company's short-term liquidity situation. You calculate your net working capital by subtracting your current liabilities from your current assets. The higher your net working capital level, the better suited you are to pay off your short-term debt. If this is the case, you can comfortably invest in new projects. If you have a low net working capital level, you are in a risky cash flow situation. Unexpected expenses could force you to sell long-term assets at a loss.

Deferred Revenue

According to the matching principle of accounting, you only recognize the revenue on a transaction upon its completion or when you physically have it. This creates an accounting problem when a client prepays you. You are not allowed to recognize the payment as an increase in your company's net worth because you have yet to complete your transaction. Because your assets increased by the cash, you must also increase your liabilities to even out your balance sheet. Deferred revenues are the liability labeling for a prepayment to your company.

Impact on Net Working Capital

You should recognize deferred liabilities as a current liability. You must make the adjustment to increase your current liabilities to calculate your net working capital level. If you do not adjust your balance sheet for a deferred liability, you will overestimate your net working capital by only recognizing additional cash received. This could cause you to overextend your business' funds and create cash flow problems when you need to pay the unrealized expenses of the deferred revenues.

About the Author

David Rodeck has been writing professionally since 2011. He specializes in insurance, investment management and retirement planning for various websites. He graduated with a Bachelor of Science in economics from McGill University.

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